The credit rating agency Fitch Ratings downgraded Finland’s credit rating to AA in July. This was due to the increase in the national debt ratio and insufficient adjustment measures. The central government is planning to introduce the inherently notorious balanced budget amendment, also known as a ‘debt brake’, in Finland. Why is debt such a hot topic? How does national debt work? Should we gradually start to reduce the debt ratio, and how should we go about doing it?
A state does not function in the same way as a household
It is a common mistake to compare the national economy to a household. A state can take on debt in its own currency, control interest rates through the central bank, raise taxes, cut spending and continue to exist forever. For individuals, however, the situation is different: they must pay back their debts during their lifetime.
In contrast, a state pays back the capital when the debt is due or takes out a new loan to replace the previous one (debt ‘refinancing’). Interest is paid annually to the owners of the debt. The debt is repaid from tax revenue, additional income gained from economic growth, or by selling assets.
There is no ‘right’ debt level
The debt-to-GDP ratio is more important than the amount of debt itself. Many countries, such as Japan, have lived for decades with a debt-to-GDP ratio above 200% without facing a serious crisis.
This indicates that investors are used to higher debt levels. If the economy grows faster than the interest on the debt, the debt ratio may even decrease without requiring spending cuts or tax increases. On the other hand, if the interest is higher than economic growth, the debt ratio can easily spiral out of control.
Although Finland’s credit rating was downgraded in July, the markets did not react strongly. Compared to Germany, Finland continues to obtain loans from the markets relatively affordably. This indicates that the markets do not expect the credit rating to be lowered in the near future.
A debt brake would bind Finland to an austerity policy
The central government is planning to add a debt brake to Finnish law, which would nominally reduce debt. The central government justifies the 40% debt brake on the basis of EU rules. However, EU rules do not require a national debt brake, and it is enough for the adjustment to be taken into account in the fiscal plan. A debt brake would bind Finland to austerity – a policy of cutting spending – for decades, which would also eat into economic growth.
The National Audit Office of Finland (VTV) has also criticised the draft law, which states that the debt ratio should be reduced by at least one percentage point of GDP for almost 50 years. This would limit investment and further shrink the welfare state.
In crisis situations, Finland must be able to support both citizens and businesses and maintain investment and service provision. The COVID-19 crisis of recent years and Russia’s war of aggression against Ukraine have shown that flexibility in crisis situations is indeed needed. Therefore, a debt brake could deepen recessions and increase long-term unemployment.
Furthermore, the Finnish population is ageing rapidly, and the need for services is increasing. Flexible economic policies are important in order to finance the costs of health and social services while simultaneously revising the economy. A debt brake could make this impossible without very strict spending cuts.
There are alternatives to spending cuts
The best way to reduce the debt ratio is to grow the economy. Therefore, policies aiming for economic growth are the most appropriate and least expensive.
Finland’s economic growth has not taken off for years. The EU’s interest rate policy has contributed to the low growth, but the austerity policy of Orpo’s Government has also been toxic for growth. The policy of cutting spending has eaten up what little growth we could have had. Of particular importance are investments in education, R&D, health care, employment and the green transition.
The policy of cutting spending has eroded the purchasing power of Finns and, through it, weakened growth and employment. In particular, increases in value-added tax are eating into domestic purchasing power.
While the central government has said that it is concerned about indebtedness, it has also handed out tax breaks to big businesses and high-income earners. Cuts to health and social services and education are being called ‘mandatory’, when in fact they are not. Alternatives to cuts would include things such as removing detrimental business subsidies and dividend tax relief for unlisted companies. Moreover, the tax cuts scheduled for next spring should be cancelled.
In other words, while a debt brake may sound like an attractive way to increase adjustment, it would most likely only be counterproductive for Finland, as it would undermine economic flexibility, deepen recessions and prevent investments in the future. Public finances do not function in the same way as households. Instead, cuts can at worst set off a negative economic spiral that, contrary to expectations, will not reduce the debt ratio, but may even increase it.